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Industry Voices

Commentary: Some hard facts about a soft landing for the U.S. economy

The position taken by Federal Reserve Chairman Jerome Powell in his recent statement to the Senate Banking Committee was good news for the U.S. economy and financial markets. For those who remained concerned that the Fed was still inclined to tap the brakes by further tightening interest rates or by hastily reducing its balance sheet, the language from the Federal Open Market Committee's January statement and the chairman's recent testimony was encouraging.

By reiterating that it has decided to pause its rate-hiking behavior for the time being and, by signaling an earlier balance sheet normalization at higher than historic levels, the Fed has taken major steps in a positive direction toward a soft landing for the U.S. economy. Historically, an economic soft landing — in which economic growth slows but a recession is averted or delayed — requires small doses of stimulus. With rates still low, a reduction in quantitative tightening may provide the Fed with just enough of a spark to modulate economic growth. The typical ramifications of such a policy change, such as improved credit spreads, stability in shorter-maturity interest rates, a steepening U.S. yield curve and a weakening U.S. dollar, should create a positive feedback loop that will help stabilize the nation's economic growth rate at a more modest level.

Risks to a soft landing

To be sure, with the recent change in the direction of fiscal policy, the possibility of a manageable slowdown in the U.S. economy has become more likely. As a result, we expect moderate U.S. growth in 2019 — around the 2% level. However, a soft landing has historically been very difficult to engineer, and we note that there are still some risks to this outcome. For example, although high employment rates often precede recessions, in the current environment lower labor force participation remains below the level achieved at the depths of the 1991 and 2001 recessions and thus provides room for continued improvement.

One of the greatest threats to a soft landing remains the pace of the Fed's efforts to trim its balance sheet, bloated by years of securities purchases in the name of quantitative easing. The Fed has now signaled its intention to reduce quantitative-tightening activity and to normalize its balance sheet at substantially higher than historic levels. Should tapering take too long, its stimulative potential could be thwarted by an unintended "crowding out" effect, as other buyers must be found for the securities that the Fed might sell. This process could drain capital from the equity and corporate fixed-income markets, creating the kind of sell-off that we saw in the fourth quarter of 2018.

In reality, the Fed can probably implement monetary policy effectively in the current economy, even with a balance sheet that is larger than it has been historically. As Mr. Powell explained to the senators, the Fed is justified in running with higher reserves based on higher regulatory demand for reserves from the banks, for example.

Concerns beyond monetary policy

There are several other factors, besides Fed policy, that may pose obstacles to a soft landing. One is lackluster capital spending growth. While the tax reform enacted in 2018 was expected to fuel an accelerated rate of capital investment, the complexity of the tax-code changes and uncertainty about trade policy likely prevented it. In fact, growth rates in capital spending have remained muted, and the ongoing lack of clarity on trade policy should keep corporate America cautious on this front. Corporate America will likely continue to await clarity on policy (trade, infrastructure, etc.) and a sustained uptick in productivity before appreciably ramping up capital spending. Thus, should economic conditions worsen — for example, further erosion in the already weak housing price appreciation rate — there would be no offsetting burst of capital spending.

In fact, excessive corporate debt is another threat to a soft landing. A large share of the tax reform windfall was diverted toward record levels of corporate share repurchases. In an environment of near record low interest rates, corporations also incurred debt to fund buybacks — and did so at elevated equity prices. Corporate balance sheets have thus become weaker, even as the Fed has taken steps to make its own balance sheet stronger. The importance of delivering a soft landing is underscored by the abundance of BBB- rated debt that could slip to junk if borrowing cost were to rise aggressively.

Finally, if the U.S. economy does achieve a soft landing, it will not be due to any help from other global economies. The European economies are continuing to experience weakness, no doubt exacerbated by uncertainties surrounding Brexit. And the performance of China's economy has been less-than-stellar, despite some government stimulus. This weakness — as well as continuing uncertainties over trade policies — means that demand for U.S. exports is not likely to bolster the U.S. economy if its growth decelerates.

Recent Fed policy announcements are steering the U.S. economy toward a soft economic landing, as the data-driven approach of the current Fed helps it navigate what Mr. Powell calls "cross-currents and conflicting signals." Still, policymakers cannot assume that all the preconditions for a soft landing have been met or are completely within the Fed's control.

Thanos Bardas is global co-head investment-grade fixed income at Neuberger Berman, Chicago. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.